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Infosys: Watch out!

Mar 18, 2005

Infosys Technologies is one of India’s premier software service companies. It is the second-largest software services exporter from the country, and is expected to notch up revenues of over US$ 1.7 bn in FY05. In this article, we attempt to briefly analyse the initiatives taken by Infosys, and the resultant impact on various components of its business, and its margins. Consistent moves up the value chain:  Over the years, Infosys has been steadily moving up the value chain in terms of services offered to clients. While custom software development and maintenance provide the stability factor, accounting for well over 50% of revenues, high-end services have seen a slow but steady increase in the share of overall revenues. The share of package implementation in overall revenues has increased from 6.0% in FY00 to 14.5% in FY04. With the company taking initiatives to grow the share of these high-end services, this is expected to increase. It has already set up a dedicated company for consulting services, Infosys Consulting.

The result of ‘moving up’: High-end services, high quality growth!
  FY00 FY01 FY02 FY03 FY04
High-end services (% of revenues) 12.9% 19.2% 23.5% 25.9% 28.5%
* Includes package implementation, consulting, testing, engineering services and products

Changes in the ‘Offshore-onsite mix’:  Another factor to observe in any software company’s revenues is the ratio of offshore services to onsite services. High-end services have a higher onsite component, as the company has to be at the client’s site in order to carry out services like package implementation like ERP, or for consulting, where it is necessary to understand the client’s business and the problems/deliverables that they want addressed.

It has been observed internationally that as a company moves up the value chain, the onsite component of revenues starts increasing. As and when the company starts showing competencies in implementing these higher-end services, it starts to move a greater proportion of this work also offshore, thus maintaining a fine mix of the two services.

Infosys has been showing a similar sort of trend, with onsite component steadily increasing from FY00 to FY03, and after that, it has shown signs of stabilizing.

Offshore to onsite and back!
  FY00 FY01 FY02 FY03 FY04
Onsite 48.5% 51.5% 50.8% 58.3% 55.1%
Offshore 51.5% 48.5% 49.2% 41.7% 44.9%

Billing rates:  In order to grow in scale and size to compete with global giants, it is necessary to graduate to provide high-end services, as Infosys has been doing. The result is an increase in the share of onsite services. Since onsite billing rates are higher than offshore rates due to higher level of skills required, this ultimately results in an increase in topline.

An analysis of the share of onsite revenues of Infosys reveals that, over the years, these have been steadily growing at a faster pace than offshore revenues, except in FY04. The explanation for this can be traced to the fact that, as the company increased its share of high-end work, a greater proportion of its revenues were derived onsite. In FY04, this has stabilized to an extent. Going forward, this stabilisation is expected to continue, as the company is expected to increasingly gain competence in the high-end services.

Onsite revenues: Leading the way, but not for long!
(US$ m) FY01 FY02 FY03 FY04
Onsite 213 277 439 585
Offshore 201 268 314 477

So, how does this fit in with the overall profitability picture?
As Infosys has moved up the value chain, its margins have been impacted negatively. In fact, there has been a steady decline in operating margins, from over 40% in FY00 to around 33% in FY04. The explanation for this stems from the fact that, as a company moves a greater proportion of work onsite to provide high-end services to its clients, it earns higher revenues due to higher billing rates earned. However, its costs also increase due to the fact that it has to pay higher salaries to domain experts needed to provide these services.

This is a clear catch-22 situation. In fact, it can be clearly observed in the table above, that in FY03, the proportion of onsite work increased from 50.8% to as much as 58.3%. The net impact of this is that operating margins fell by almost 500 basis points in FY03.

A ‘Catch-22’ situation: High-end services, but lower margins!
  FY00 FY01 FY02 FY03 FY04
High-end services (% of revenues) 12.9% 19.2% 23.5% 25.9% 28.5%
EBIDTA margin 39.3% 40.2% 39.9% 35.1% 33.3%
Net profit margin 32.4% 32.8% 31.0% 26.4% 26.1%

Going forward, we expect Infosys to increase its share of high-end revenues. Thus, while we expect revenues to rise at a fast pace, we believe that there will be a downward pressure on the margins. Apart from this, we expect other factors like the need to scale up operations at a rapid pace, rising employee costs, the risk of attrition and increase in hiring and training costs also to put pressure on margins.

Our view
We maintain Infosys as one of our top picks in the sector for a long-term horizon. However, investors need to be slightly cautious in the short-to-medium term, given the valuations. Valuations at this juncture fully factor in expected earnings growth in FY06, and thus, investing in the stock could be fraught with risk in the short term.

But in the long term, if one believes that there is a strong case for outsourcing and that Infosys has the management depth to consistently deliver results, there is an upside. To that extent, one has to align the investment horizon to the long-term plans of the management to benefit. Patience is a virtue in this game.

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